Review of 2019 (Part 1)

In the last two weeks of 2019 we are running material which we have primarily covered during the year but which discusses the important developments during this year.  As we reflect on what has transpired during the year, let’s also think about how we can improve the tax procedure process going forward.  We welcome your comments on the most important developments in 2019 related to tax procedure.

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Important IRS Announcements

CC Notice 2020-002Contacting IRS attorney by email

This recently-issued Chief Counsel notice announces a process for email communications between practitioners and Chief Counsel attorneys. Formerly, communication with Chief Counsel attorneys was difficult, due to internal restrictions on emailing taxpayer information. Under the new notice, Chief Counsel employees can now exchange email with taxpayers and practitioners using encrypted email methods. This new policy will likely prove helpful for practitioners, who can now make quicker progress in working with Chief Counsel to resolve Tax Court litigation or to prepare for trial.

CC Notice 2019-006Deference

This notice is a policy statement, warning Treasury and the IRS about the current judicial state of play on deference to agency regulations. It states that Chief Counsel attorneys will no longer argue that courts should apply Chevron or Auer deference to sub-regulatory guidance, such as revenue rulings, revenue procedures, or other notices. This guidance should be read in conjunction with the Supreme Court’s decision last term in Kisor v. Wilkie, in which the Court scaled back the applicability of Auer deference and indicated a willingness to rethink the scope of agency deference.  As tax lawyers it’s easy to overlook important administrative law decisions such as Kisor, but we all need to recognize the importance of such decisions on how to practice before the IRS. 

See Keith Fogg, Notices on Communicating with IRS, Chief Counsel’s Office and Deference, Procedurally Taxing (Oct. 28, 2019), https://procedurallytaxing.com/notices-on-communicating-with-irs-chief-counsels-office-and-deference/#comments

Altera, Good Fortune, & Baldwin – Deference to regulations

The 9th Circuit recently reversed the Tax Court’s decision that the transfer pricing regulations at issue in Altera Corp. v. Commissioner, 926 F.3d 1061 (9th Cir. 2019), rev’g 145 T.C. 91 (2015) were invalid because they lacked a “reasonable explanation” as required by the Supreme Court in State Farm.  A majority of the Ninth Circuit concluded that Treasury made “clear enough” its decision by including “citations to legislative history” that the dissent said were “cryptic.” The 9th Circuit recently denied Altera’s petition rehearing en banc over a vigorous dissent from three judges, making the case a possible vehicle for certiorari and the latest Supreme Court reexamining of administrative deference.

In contrast, a decision by the D.C. Circuit in Good Fortune Shipping v. Commissioner, 897 F.3d 256 (D.C. Cir. 2018), rev’g 148 T.C. 262 (2017), held invalid regulations that narrowed an excise tax exemption for corporations owned by shareholders in certain countries.  The regulations said ownership of bearer shares could not be used to qualify for the exemption.  The preamble to the regulations suggested the rule was needed because of the difficulty of reliably tracking the location of the owners of bearer shares, but the court observed that other regulations issued by the agency suggested that the location of the owners of bearer shares were becoming easier to track over time.

On the other hand, in Baldwin v. United States, 921 F.3d 836 (9th Cir. 2019), reh’g denied, 2019 U.S. App. LEXIS 18968 (9th Cir. June 25, 2019), petition for cert. filed, 2019 WL 4673331 (U.S. Sept. 23, 2019) (No. 19-402), the Ninth Circuit held that a claim for refund was late because the common law mailbox rule was supplanted by Treas. Reg. § 301.7502-1(e)(2)(i).  Because the Ninth Circuit had previously held the statutory rule (IRC § 7502) provided a safe-harbor that supplements the common-law rule, the district court held the regulations invalid.  Under the Supreme Court’s holding in Brand X, “[a] court’s prior judicial construction of a statute trumps an agency construction otherwise entitled to Chevron deference only if the prior court decision holds that its construction follows from the unambiguous terms of the statute and thus leaves no room for agency discretion.”  In this case, the regulations trumped the Ninth Circuit’s prior interpretation of IRC § 7502 because it said its earlier decision was filling a statutory gap.  Litigators have indicated this case may be the perfect vehicle for the Supreme Court to consider overruling Chevron or Brand X. 

See Andrew Velarde, Can the Humble Mailbox Rule Bring Monumental Changes to Chevron? 94 Tax Notes Int’l 412 (Apr. 29, 2019) (noting that Justices Thomas, Gorsuch, Kavanaugh, Alito, Breyer, and Chief Justice John Roberts have arguably expressed reservations about an overly broad reading of Chevron).

Taxpayer First Act (“TFA”)

Innocent Spouse changes/Effect of 6015 (e)(7)

The TFA made perhaps unintentional but significant changes regarding the Tax Court’s review of appeals of adverse innocent spouse determinations.  The change is codified at 6015(e)(7) Such appeals will be reviewed de novo (codifying previous Tax Court precedent). This part of the new law regarding the standard for review is uncontroversial and will not result in changes for those seeking innocent spouse relief; however, the legislation changes the scope of review.  Previously, the innocent spouse proceeding went forward with no restrictions on the information the taxpayer could present in the Tax Court.  Now, the scope of review is limited to the administrative record plus the Tax Court can consider “newly discovered or previously unavailable” evidence. While these provisions may seem innocuous, they also may lead to significant new disadvantages for taxpayers. For one, innocent spouse cases present uniquely burdensome evidentiary issues for taxpayers. Presenting evidence of spousal abuse, for example, may be difficult, especially if police or medical reports do not exist in the administrative record. Meanwhile, the one exception to the administrative record, “newly discovered or previously unavailable” evidence, remains ill-defined in the statute and may prove to be a source of confusion for taxpayers and practitioners. Important evidence that a taxpayer may already possess – thus not making it “newly discovered or previously unavailable” – but didn’t include in the administrative record could potentially be excluded. For pro se taxpayers in particular, who may not be aware of the relevance of certain documents when making their case, this is a particular challenge.

The first few Tax Court cases implicating 6015(e)(7) have begun to emerge and may provide more clarity. One potential judicial solution to the issue would be for the Tax Court to remand cases with under-developed records back to the IRS.

Carlton Smith, Should the Tax Court Allow Remands in Light of the Taxpayer First Act Innocent Spouse Provisions?, Procedurally Taxing (Oct. 17, 2019), https://procedurallytaxing.com/should-the-tax-court-allow-remands-in-light-of-the-taxpayer-first-act-innocent-spouse-provisions/

Keith Fogg, First Tax Court Opinions Mentioning Section 6015(e)(7), Procedurally Taxing (Oct. 16, 2019), https://procedurallytaxing.com/first-tax-court-opinions-mentioning-section-6015e7/

Christine Speidel, Taxpayer First Act Update: Innocent Spouse Tangles Begin, Procedurally Taxing (Oct. 10, 2019), https://procedurallytaxing.com/taxpayer-first-act-update-innocent-spouse-tangles-begin/

Steve Milgrom, Innocent Spouse Relief and the Administrative Record, Procedurally Taxing (July 9, 2019), https://procedurallytaxing.com/innocent-spouse-relief-and-the-administrative-record/

Carlton Smith, Congress Set to Enact Only Now-Unneeded Innocent Spouse Fixes, Part 2, Procedurally Taxing (Apr. 4, 2019), https://procedurallytaxing.com/congress-set-to-enact-only-now-unneeded-innocent-spouse-fixes-part-2/

Carlton Smith, Congress Set to Enact Only Now-Unneeded Innocent Spouse Fixes, Part 1, Procedurally Taxing (Apr. 3, 2019), https://procedurallytaxing.com/congress-set-to-enact-only-now-unneeded-innocent-spouse-fixes-part-1/

Ex parte in TFA and CDP

The TFA does not specifically address ex parte communications between appeals and examinations or collections personnel. However, it does codify appeals’ status as an independent office, which may further strengthen arguments against ex parte communication. The currently applicable ex parte restrictions are found in Rev. Proc. 2012-18, which sets forth extensive guidance on permissible and impermissible forms of ex parte communications.

 In CDP proceedings, ex parte communications can potentially occur between appeals officers and revenue officers via the transmission of the administrative file to Appeals. Rev. Proc. 2012-18 prohibits the inclusion of material that “would be prohibited if . . . communicated to Appeals separate and apart from the administrative file.” But as demonstrated by a recent case, Stewart v. Commissioner, this may be a high bar for taxpayers to clear in challenging such communications. In Stewart, the revenue officer included contemporaneous notes in the file that indicated the taxpayer’s representation was somewhat uncooperative during a field meeting. The Tax Court declined to accept the taxpayer’s argument that the notes were prejudicial and ruled in favor of the Commissioner. 

See Keith Fogg, Application of Ex Parte Provisions in Collection Due Process Hearing, Procedurally Taxing (Sep. 19, 2019), https://procedurallytaxing.com/application-of-ex-parte-provisions-in-collection-due-process-hearing/

Taxpayer protection program

Identify fraud has been a consistent and significant problem for the IRS. But the Service’s new procedures for protecting taxpayer information may be unduly burdensome, particularly for taxpayers who need representation with time-sensitive matters. For those representing taxpayers whose returns are flagged as potential victims of identity theft, the process of authenticating identity is difficult and requires knowledge of taxpayer personal information that may not be readily available, such as place of birth or parent’s middle name. The burden is such that it may even implicate the Taxpayer Bill of Rights (TBOR)’s “right to retain representation”. By de facto requiring that the taxpayer actively participate in the identity verification process, the taxpayer is effectively deprived of their right to have their representative act for them in dealings with the IRS.

See Barbara Heggie, Taxpayer Representation Program Sidesteps Right to Representation, Procedurally Taxing (Oct. 3, 2019), https://procedurallytaxing.com/taxpayer-protection-program-sidesteps-right-to-representation/

VITA referrals to LITCs

Especially relevant for our purposes, the TFA “encourages” VITA programs to advise participating taxpayers about the availability of LITCs and refer them to clinics. This is a helpful step, which strengthens the connection between VITA and LITCs and may help inform eligible taxpayers of the existence of their local LITC.

Ninth Circuit Denies Request for En Banc Hearing by Altera

We have written about Altera v. Commissioner on many occasions because it was such an important decision by the Tax Court and because of the interesting twists in the case at the circuit level.  We have written many posts on this case.  You can find some here, here, here, here and here.  Today, the Ninth Circuit has rejected the request for an en banc hearing.  The rejection of the request is here.  Three judges dissented from the decision not to hear the case en banc.  This leaves Altera with the decision to press on to the Supreme Court or to accept the decision.  For those not following the case, the issue concerns the manner in which the IRS promulgated the regulations.  The Tax Court was so uncomfortable with the process that it struck down the applicable regulations in a unanimous vote of the full court.  The Ninth Circuit panel reversed the Tax Court in a 2-1 vote.

Review of Hemel and Kamin’s The False Promise of Presidential Indexation

In The False Promise of Presidential Indexation, which was recently published in the Yale Journal of Regulation, Professors Daniel Hemel and David Kamin have written an important article that considers whether the executive branch has the power to index capital gains for inflation.  In addition to critiquing the measure as a matter of policy, the authors make a persuasive case that Treasury, absent additional legislation, does not have the authority on its own to index capital gains.

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The article raises the question as to which institutional actor in our government should be responsible for generating a change in law that would have a major impact on both the fisc and the tax system.  This question periodically appears in tax administration; longtime readers of the blog may connect this to other issues; for example, in Loving v IRS a DC district court opinion affirmed by the DC Circuit held that without explicit Congressional authority the IRS could not administratively require hundreds of thousands of previously unlicensed preparers to take a competency test and be responsible for continuing education requirements. 

The article provides current and historical context for indexing capital gains, including a 2018 statement by President Trump that he is “thinking about it very strongly” and a discussion of the last time that there seemed to be serious executive consideration of this proposal, in the waning days of the first Bush administration.  The idea seems to be gaining momentum, as  reports from this summer indicate that President Trump has put this issue on the front burner.

The issue of capital gains indexing is really an issue of basis indexing, an issue that would apply to both capital assets and ordinary assets. Since as the authors point out over 98% of the gain reported was on capital assets (2015 figures), the shorthand way to refer to this issue is on the power to index capital gains. The technical issue turns on whether Treasury could index basis for inflation through regulations. 

The authors discuss why at the time of the proposal’s earlier consideration in the 1990’s  there was general (though not uniform) consensus that Treasury did not have the authority to unilaterally index basis for inflation, including legal opinions from Treasury’s General Counsel and the Justice Department’s Office of Legal Counsel (OLC). As I gear up again to teach basic tax for the fall semester, as I tell my students at Villanova, it is crucial to start with the Internal Revenue Code when thinking about this issue. Section 1012(a) (first enacted as part of the Revenue Act of 1918), says that “[t]he basis of property shall be the cost of such property.” 

The article (starting at page 707) nicely summarizes the main reasons why in 1992 the OLC concluded that “cost” was not ambiguous, looking at its dictionary definition, early Treasury practice, court decisions, and other IRC provisions. Absent finding any ambiguity in the term cost, OLC concluded that cost meant the price paid for an item, and Treasury could not on its own change the meaning of it by regulation.

Hemel and Kamin’s article then discusses developments since the first Bush presidency, including case law outside tax that some proponents have suggested supports finding that cost is indeed an ambiguous term, general administrative law developments, and the tax law’s place within administrative law.  

As to general administrative law, the authors persuasively argue that developments since the early 1990’s make it even harder to support a regulation based capital gains indexing. A key part of the discussion is the authors’ discussion of the “major questions” doctrine, where a number of Supreme Court decisions deny Chevron deference to issues that have deep economic and social significance in the absence of clear Congressional direction to agencies. As the authors note, 

[t]he advent of the major questions doctrine is the most significant post-1992 doctrinal development bearing upon the legality of the presidential indexation proposal.  And it does not bode well for the idea. While the exact boundaries of the major questions doctrine remain unclear, there are compelling arguments that the decision to index basis for inflation or not should qualify as a major question.

As support for this type of change being considered within the major questions doctrine, the authors point to estimates that peg the cost of indexing to be in the magnitude of $10-20 billion a year. They also discuss Supreme Court cases warning against reading delegation into cryptic legislative language:

As Justice Scalia wrote for the Court in Whitman v. American Trucking Association, citing to both MCIand Brown &Williamson: “Congress . . . does not alter the fundamental details of a regulatory scheme in vague terms . . . . [I]t does not, one might say, hide elephants in mouseholes.” And as we have emphasized, indexing basis for inflation would indeed be an elephant.

Drilling down deeper, the authors discuss general Chevron developments and the subtle but important difference in now Justice Kavanaugh’s take on the major questions doctrine-developments that they argue make the case for indexing even weaker. While now Justice Kavanaugh (who authored the DC Circuit Loving opinion, which in part relied on the major case doctrine as justification for concluding that IRS acted outside its authority in its efforts to require mandatory testing and education for unlicensed preparers) is just one member of the Court, Hemel and Kamin also discuss the general discomfort that many of the justices feel for Chevron, including their take that the current “judicial zeitgeist…is decidedly anti-Chevron.”

The authors also address somewhat more difficult questions when they consider whether any party would have standing to challenge regulations. After all, the regulations appear to only help taxpayers, and as the authors note, scholars such as Larry Zelenak considering the issue in the 1990’s felt that without there being a disadvantaged taxpayer, it would be difficult to find a party with standing to challenge the regulations. The authors again look to post 1990’s developments to sidestep the need for individual taxpayer harm, including the possibility that Congress or states could have standing to sue. In addition, the authors creatively argue that indexing would harm some, including brokers, who would bear additional costs to comply with reporting obligations, and taxpayers subject to the charitable deduction cap in Section 170.

Conclusion

The Hemel and Kamin article provides important legal context on this issue. If the Trump administration moves forward with the idea, this article will be required reading for those interested in and likely litigating the issue. Even if the Trump Administration declines to move forward with this idea, given current dysfunction in Washington and the strained relations between the branches, I suspect that there will be even greater temptation to use the IRS to sidestep Congress to achieve policy objectives that have at best a tenuous link to the statutory language. As such, the legal issues Hemel and Kamin discuss are generally important for tax administration, and will likely resurface even when this particular debate goes away, or perhaps hibernates for another generation to consider and likely discount.

Ninth Circuit Holds Reg. Validly Overrules Case Law; Disallows Parol Evidence of Timely Mailing

In Baldwin v. United States, 2019 U.S. App. LEXIS 11036 (9th Cir. April 16, 2019), in a case of first impression in the appellate courts, the Ninth Circuit has held that a 2011 regulation under section 7502 is valid under the deference rules of Chevron, U.S.A., Inc. v. Natural Res. Def. Council, Inc., 467 U.S. 837 (1984), and Nat’l Cable & Telecomms. Ass’n v. Brand X Internet Servs., 545 U.S. 967 (2005), and therefore it invalidates all prior case law in some Circuits (including the Ninth) holding that the common law mailbox rule can be used to prove the IRS’ timely receipt of a document by parol evidence. The Circuit reversed the district court and directed it to dismiss the case because the only evidence offered of timely mailing of a Form 1040X refund claim was the testimony of the Baldwins’ employees that they remember timely posting the envelope containing the claim by regular mail months before the claim was due – evidence that is only relevant if the common law mailbox rule still exists in the tax law. I blogged on Baldwin before the oral argument here.

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Facts

Baldwin is a tax refund suit. There, the taxpayers reported a loss on their 2007 income tax return, filed on or before the extended due date of October 15, 2008. They wished to file an amended return for 2005, carrying back the 2007 loss to generate a refund in 2005. Under section 6511(d), this had to be done by filing the amended return within three years of the due date of the return generating the loss – i.e., by October 15, 2011. The taxpayers introduced testimony of their employees that the employees mailed the 2005 amended return by regular mail on June 21, 2011 from a Hartford Post Office to the Andover Service Center. But, the IRS claimed it never received the Form 1040X.

The California district court followed Anderson v. United States, 966 F.2d 487 (9th Cir. 1992), in which the Ninth Circuit had held that the enactment of section 7502 in 1954 did not eliminate the common law mailbox rule and still allowed taxpayers to prove by parol evidence that a document not sent by registered or certified mail or a designated private delivery service was actually mailed and so was presumed to have been received by the IRS prior to the due date. The district court credited the testimony of the employees and held that the refund claim was timely filed. The court later awarded the taxpayers a refund of roughly $167,000 and litigation costs of roughly $25,000.

The DOJ appealed the loss to the Ninth Circuit, where it argued that the suit should have been dismissed because the refund claim was not timely filed. The DOJ argued that in August 2011, the IRS adopted a regulation intended to overrule some Circuit court opinions (including Anderson) that had held that the common law mailbox rule still survived the enactment of section 7502. At least one other Circuit had agreed with Anderson; Estate of Wood v. Commissioner, 909 F.2d 1155 (8th Cir. 1990); but several other Circuits had disagreed and held that the common law mailbox rule did not survive the enactment of section 7502. See Miller v. United States, 784 F.2d 728 (6th Cir. 1986)Deutsch v. Commissioner, 599 F.2d 44 (2d Cir. 1979)See also Sorrentino v. Internal Revenue Service, 383 F.3d 1187 (10th Cir. 2004) (carving out a middle position).

As amended by T.D. 9543 at 76 Fed. Reg. 52,561-52,563 (Aug. 23, 2011), Reg. § 301.7502-1(e)(2)(i) provides, in relevant part:

Other than direct proof of actual delivery, proof of proper use of registered or certified mail, and proof of proper use of a duly designated [private delivery service] . . . are the exclusive means to establish prima facie evidence of delivery of a document to the agency, officer, or office with which the document is required to be filed. No other evidence of a postmark or of mailing will be prima facie evidence of delivery or raise a presumption that the document was delivered.

Ninth Circuit Opinion

The Ninth Circuit began its analysis with a little history: Prior to 1954, there was no timely-mailing-is-timely-filing provision in the Internal Revenue Code. That meant that the only way to timely file a document was for it to arrive at the IRS on or before the due date. At common law, there is a presumption that a properly-mailed envelope will arrive in the ordinary time for mail to go between its origin and destination. At common law, a party could bring in any evidence (including testimony) to show that the envelope likely arrived at the IRS on or before the due date.

In 1954, Congress added section 7502 to the Code. We all think of it as a provision that allows a mailing made on or before the due date to be treated as timely filed, whether or not the IRS receives the document on, before, or after the due date. But, that is not an accurate summary of the provision. In fact, subsection (a) provides, in general, that if a document is delivered to the IRS by the United States mail after the due date, then the date of the United States postmark on the envelope is deemed to be the date of delivery (i.e., filing). Other rules extend the benefits of subsection (a) to designated private delivery services and electronic filing, but only pursuant to regulations. However, subsection (c) also includes a presumption of delivery that applies in the case of use of certified or registered mail: If an envelope is sent certified or registered mail, then (1) the certification or registration is prima facie evidence that the envelope was delivered to the place to which it was addressed and (2) the date of registration or certification is deemed the date of the postmark for purposes of subsection (a).

In Anderson, the Ninth Circuit had held that subsection (c)’s presumption of delivery language (and the regulations thereunder) did not supplant the common law way to prove delivery on or before the due date. Rather, subsection (c) provided only a safe harbor for proof of delivery if certified or registered mail was used. Where ordinary mail was used, there was no statutory provision presuming or denying proof of delivery, so the common law mailbox rule could still operate to allow proof of timely mailing by any evidence.

In Baldwin, the Ninth Circuit noted that under Chevron Step 2, a court must defer to an agency’s interpretation in a regulation if that interpretation is one of the reasonable ways an ambiguous statute could be interpreted. And in Brand X, the Supreme Court held that, unless an appellate court opinion had said that the statute was unambiguous (and therefore Chevron Step 1 would deny any regulatory input), an agency could issue valid regulations overruling that appellate precedent.

In the case of the 2011 regulation under section 7502, the Ninth Circuit in Baldwin held that an interpretation that section 7502 completely supplanted the common law mailbox rule was one of the reasonable interpretations of that statute and that the Ninth Circuit had not, in its Anderson opinion, rested its holding on the unambiguous nature of section 7502’s language. Therefore, under Chevron and Brand X, the regulation barring the use of the common law mailbox rule was valid.

The taxpayers had two arguments that the Ninth Circuit quickly dismissed:

First, the taxpayers argued that there is a rule of construction that makes repeal of common law rules by statute not to be easily implied. With respect to this argument, the Ninth Circuit noted a contrary rule of construction (one that other Circuits had relied on) that when a statute speaks on an issue and makes an exception, that statutory exception eliminates all nonstatutory exceptions. The Ninth Circuit held that the subsection (c) rules presuming delivery in the case of certified or registered mail could benefit by the latter interpretive rule. Thus, these countervailing statutory rules of construction could lead to two different reasonable interpretations of the statute.

Second, the taxpayers argued that the regulation was improperly being applied retroactively, since they had claimed that they mailed the envelope in June 2011, but the regulation was only adopted in August 2011. But, the Ninth Circuit pointed out that the regulation was effective for all documents mailed after September 21, 2004 (the date the regulation was first proposed), and the court did not find that such retroactive effective date violated section 7805(b)(1)(B), which allows the IRS to make its regulations retroactive to the date they are first proposed.

Observations

Several Supreme Court Justices have recently criticized Chevron and Brand X. It is interesting that Judge Watford, who wrote the Baldwin opinion, only predicated the panel’s ruling for the IRS on the basis of reliance on those two opinions. What, then, happens if Chevron and Brand X are overruled? Will the Ninth Circuit’s precedent then revert to Anderson, which allows use of the common law mailbox rule?

Judge Watford also seems to be deliberately vague in his opinion as to the ground on which the district court should dismiss the case on remand. He does not say the dismissal should be for lack of jurisdiction (FRCP 12(b)(1)) or for failure to state a claim (FRCP 12(b)(6)). It would not much matter in this case whether the section 6511 filing deadline were jurisdictional or not, but it might matter in a future case (e.g., one where there was an argument for waiver, forfeiture, or estoppel, but not equitable tolling (see United States v. Brockamp, 519 U.S. 347 (1997) (holding the deadline not subject to equitable tolling, but not discussing whether the deadline is jurisdictional)). Indeed, Judge Watford’s Baldwin opinion really relies on section 7422(a), which requires the filing of a refund claim before a refund suit may be maintained. The opinion states that section 7422(a) also requires a timely claim. In fact, Judge Watford only writes:

The Baldwins then brought this action against the United States in the district court. Although the doctrine of sovereign immunity would ordinarily bar such a suit, the United States has waived its immunity from suit by allowing a taxpayer to file a civil action to recover “any internal-revenue tax alleged to have been erroneously or illegally assessed or collected.” 28 U.S.C. § 1346(a)(1). Under the Internal Revenue Code (IRC), though, no such action may be maintained in any court “until a claim for refund or credit has been duly filed” with the IRS, in accordance with IRS regulations. 26 U.S.C. § 7422(a); see United States v. Dalm, 494 U.S. 596, 609 (1990). To be “duly filed,” a claim for refund must be filed within the time limit set by law. Yuen v. United States, 825 F.2d 244, 245 (9th Cir. 1987) (per curiam).

Judge Watford is the author of the opinion in Volpicelli v. United States, 777 F.3d 1042 (9th Cir. 2015), which we blogged on here and where I was amicus. In that opinion, he held that the then-9-month filing deadline to bring a wrongful levy suit in district court is not jurisdictional and is subject to equitable tolling under recent Supreme Court case law making filing deadlines now only rarely jurisdictional. Note that his language above from Baldwin does not mention the word “jurisdictional” with regard to section 7422(a)’s requirement. Judge Watford may not be wanting to say that section 7422(a)’s administrative exhaustion requirement is jurisdictional, rather than a nonjurisdictional mandatory claims processing rule possibly subject to waiver, forfeiture, or estoppel. It is true that in Dalm (which he cites only with a “see”), the Supreme Court called the requirements of sections 7422(a) and 6511 jurisdictional with respect to a refund suit, but the reasoning of Dalm does not accord with current Supreme Court case law. In 2016, the Seventh Circuit questioned whether Dalm is still good law, though it did not reach the question, writing:

The Gillespies do not respond to the government’s renewed argument that § 7422(a) is jurisdictional, though we note that the Supreme Court’s most recent discussion of § 7422(a) does not describe it in this manner, see Unites States v. Clintwood Elkhorn Mining Co., 553 U.S. 1, 4-5, 11-12 (2008). And other recent decisions by the Court construe similar prerequisites as claims-processing rules rather than jurisdictional requirements, see, e.g., United States v. Kwai Fun Wong, 135 S. Ct. 1625, 1632-33 (2015) (concluding that administrative exhaustion requirement of Federal Tort Claims Act is not jurisdictional); Reed Elsevier, Inc. v. Muchnick, 559 U.S. 154, 157 (2010) (concluding that Copyright Act’s registration requirement is not jurisdictional); Arbaugh v. Y&H Corp., 546 U.S. 500, 504 (2006) (concluding that statutory minimum of 50 workers for employer to be subject to Title VII of Civil Rights Act of 1964 is not jurisdictional). These developments may cast doubt on the line of cases suggesting that § 7422(a) is jurisdictional. See, e.g., United States v. Dalm, 494 U.S. 596, 601-02 (1990).

Gillespie v. United States, 670 Fed. Appx. 393, 394-395 (7th Cir. 2016) (some citations omitted). It was this passage from Gillespie that the DOJ cited as grounds for its need to file a post-oral argument memorandum of law in Tilden v. Commissioner, 846 F.3d 882 (7th Cir. 2017), arguing that the section 6213(a) Tax Court deficiency petition filing deadline is jurisdictional and not subject to waiver. The DOJ won that argument in that case, but it is currently before the Ninth Circuit on the issues of jurisdictional and equitable tolling in companion cases on which we previously blogged here.

Quick Takes: Altera, Senate Finance Committee Testimony on IRS Reform

I am trying to meet a deadline before a last gasp of summer vacation in California, and I have had a little less time than usual for blogging.  Tax procedure and tax administration developments wait for no one, however, and much has been happening this week. I will briefly discuss and add some links to two major developments: the Altera case and the Senate Finance Committee Subcommittee on Tax and IRS Oversight hearing.

Altera

As I am sure many readers know, the Ninth Circuit reversed the Tax Court in the heavily anticipated case of Altera v Commissioner, a case we have blogged numerous times. The basic holdings in the Ninth Circuit case all involved the broader question as to whether Treasury exceeded “its authority in requiring Altera’s cost-sharing arrangement to include a particular distribution of employee stock compensation costs.”

The Ninth Circuit, in a divided opinion that included now deceased Judge Stephen Reinhardt in the majority, concluded that the Treasury did not. In so doing, it held that Treasury did not violate the APA in its rulemaking, and under Chevron the court deferred to Treasury’s take on the substantive issue of allocation of employee stock compensation costs.

We will have more on this decision in PT. In the meantime, here are some comments on the decision in the blogosgphere:

Dan Shaviro in Start Making Sense trumpets the 9thCircuit getting to the right outcome

Leandra Lederman in The Surly Subgroup, who like Professor Shaviro wrote an amicus arguing for reversal, succinctly summarizes the holding

Jack Townsend, who in his Federal Tax Procedure blog, in addition to linking to his excellent and free tax procedure book offers his take on the case, including his gloss on Chevron and his forecast that if the Supreme Court gets to this one there is a good chance for the Supremes “screwing it up”

Chris Walker at Notice and Comment who expresses unease about the process, especially the aspect of including as part of the majority a judge who passed away prior to the Court’s issuing the opinion

Alan Horowitz at Miller & Chevalier’s Tax Appellate blog, discussing the holding and likely petition for rehearing by the full circuit

Senate Hearing on Tax Administration

The Senate Finance Committee’s Subcommitte on Taxation and IRS Oversight had a hearing yesterday on improving tax administration.

Here is a link to the audio; witnesses, whose written testimony is linked above, were

  • Caroline Bruckner, Managing Director of the Kogod Tax Policy Center at American University ;
  • Phyllis Jo Kubey, Member of the National Association of Enrolled Agents and the IRS Advisory Council ;
  • Nina Olson, the National Taxpayer Advocate ;
  • John Sapp, the current Chair of the Electronic Tax Administration Advisory Committee advising the Internal Revenue Service, and
  • Rebecca Thompson, the Project Director of the Taxpayer Opportunity

Senator Portman’s introductory statement is here—in it he notes the 20thanniversary of the IRS Restructuring and Reform Act, and how he and Senator Cardin recently introduced the Taxpayer First Act(following the House passing its version of legislation).

The National Taxpayer Advocate blogged on the hearing, including her take encouraging “everyone who cares about improving tax administration to watch the hearing and read the testimony submitted.”

Does the Mailbox Rule Survive a 2011 Reg. Under Section 7502?

We welcome back frequest guest blogger Carl Smith who discusses important forthcoming arguments regarding the mailbox rule.  This seemingly simple procedural provision gives rise to its fair share of litigation because it can make or break a case.  The cases that Carl flags are worth watching for those in need of the mailbox rule to preserve the timeliness of a submission.  Keith

 Before section 7502 was added to the Internal Revenue Code in 1954, courts determined the timeliness of various filings required under the Internal Revenue Code under a common law mailbox rule under which, if there was credible extrinsic evidence of timely mailing via the U.S. mails, then a document was presumed to have been delivered (despite denials of receipt), and if the mailing was made before the filing date, the mailing effected a timely filing. Of course, the use of certified or registered mail was excellent proof of timely mailing under the mailbox rule, but testimony about timely use of regular mail could be believed by the court, as well.

Over the years, some Circuits have faced the issue of whether the enactment of the statutory timely-mailing-is-timely-filing provision of section 7502 preempted or supplemented the mailbox rule. Compare Anderson v. United States, 966 F.2d 487 (9thCir. 1992)(mailbox rule still valid); Estate of Wood v. Commissioner, 909 F.2d 1155 (8th Cir. 1990)(same); withMiller v. United States, 784 F.2d 728 (6th Cir. 1986)(mailbox rule preempted by section 7502); Deutsch v. Commissioner, 599 F.2d 44 (2d Cir. 1979)(same). See alsoSorrentino v. Internal Revenue Service, 383 F.3d 1187 (10th Cir. 2004)(carving out a middle position).

In 2011, a Treasury Regulation under section 7502 was amended to specifically provide, in effect, that the common law mailbox rule no longer operated under the Code.  Since then, a few district courts have faced the question of the validity of this regulation.  Two courts have held the regulation valid under the deference rules of Chevron, U.S.A., Inc. v. Natural Res. Def. Council, Inc., 467 U.S. 837 (1984).  McBrady v. United States, 167 F. Supp. 3d 1012, 1017 (D. Minn. 2016);Jacob v. United States, No. 15-10895, 2016 WL 6441280 at *2 (E.D. Mich. Nov. 1, 2016).  Another district court, in an unpublished opinion in a tax refund suit, followed Andersonand applied the mailbox rule, without discussing the regulation.  Baldwin v. United States, No. 2:15-CV-06004 (C.D. Cal. 2016).

While no court of appeal has yet ruled on the validity of the regulation, on August 31, 2018, the Ninth Circuit will hear oral argument both on the government’s appeal of Baldwinand the taxpayers’ allegedly late appeal from an unrelated Tax Court Collection Due Process (CDP) case.  Both cases squarely present the issue of whether the Ninth Circuit should hold that its Andersonopinion has been superseded by a Treasury regulation abolishing the mailbox rule – a regulation that must be considered valid under Chevrondeference.

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Baldwin

Baldwin is a tax refund suit.  There, the taxpayers reported a loss on their 2007 income tax return, filed on or before the extended due date of October 15, 2008.  They wished to file an amended return for 2005, carrying back the 2007 loss to generate a refund in 2005.  Under section 6511(d), this had to be done by filing the amended return within three years of the due date of the return generating the loss – i.e., by October 15, 2011.  The taxpayers, while living in Connecticut, had properly filed their original 2005 return with the Andover Service Center, but by 2011, original returns of Connecticut residents needed to be filed at the Kansas City Service Center.  In 2011,Reg. § 301.6402-2(a)(2)provided that “a claim for credit or refund must be filed with the service center serving the internal revenue district in which the tax was paid.” That would be Andover.  But, instructions to the 2010 Form 1040X (the one used by the taxpayers) told Connecticut taxpayers to file those forms with Kansas City, where original Forms 1040 for 2010 were now being filed.  (In 2015, the regulation was amended to provide that amended returns should be filed where the forms direct, not where the tax was paid.)

The taxpayers introduced testimony by one of their employees that the employee mailed the 2005 amended return by regular mail on June 21, 2011 from a Hartford Post Office to the Andover Service Center.  But, the IRS claimed it never received the Form 1040X prior to October 15, 2011, and that the filing was in the wrong Service Center.

The district court credited the testimony of mailing, citing the Anderson Ninth Circuit opinion that allowed for the common law mailbox rule to apply.  The Baldwincourt’s opinion does not mention the August 23, 2011 amendment to the regulation under section 7502 (quoted below) that purports to preempt use of the mailbox rule.  The court went on to find that, given the conflict between the regulation under section 6402 and the form instructions, a taxpayer was then “simply required . . . [to] mail his amended return in such a way that it would, as a matter of course, be delivered to the proper service center to handle the claim within the statutory period.”  Finding that this was done here, the court held the refund claim timely filed.  The Court also observed:  “The fact that the IRS routinely forwards incorrectly addressed refund claims as a matter of course also suggests that the IRS does not consider an address problem to be fatal to a refund claim.”

Then, the Baldwin court, over the government’s objections, found that a net operating loss had been incurred in 2007 and could be carried back to 2005, resulting in a refund due the taxpayers of $167,663.  To add insult to injury, the court also held that the government’s litigating position in the case, after a certain point, was not substantially justified, so the court imposed litigation costs payable to the taxpayers under section 7430 of $25,515.

The government appealed, arguing not only that there was no valid net operating loss in 2007 to be carried back (and so the litigation costs, as well, should not have been imposed), but that the district court lacked jurisdiction because the refund claim was not filed within the time set forth in section 6511(d).

Waltner

The Waltners are a couple who have been to the Tax Court may times, and even have been sanctioned under section 6673for making frivolous arguments (even their attorney has sometimes been sanctioned thereunder).  Their Tax Court case at Docket No. 8726-11L involved an appeal by them of multiple CDP notices of determination involving multiple years of income tax and frivolous return penalties under section 6702.  In an unpublished orderon April 21, 2015, Judge Foley granted the IRS’ motion for summary judgment with respect to some of the notices of determination, but not as to all notices.  The parties later reached a settlement on the other notices, which was embodied in a stipulated decision entered by the court on January 21, 2016.  Under section 7483, this started a 90-day window in which the Waltners had to file any notice of appeal.

An August 9, 2016 unpublished order of then-Chief Judge Marvel describes what happened next:

On August 4, 2016, petitioners electronically filed a Statement Letter to the Clerk of the U.S. Tax Court (With Ex.).  Among other things, in that Statement petitioners assert that: (1) on April 15, 2016, petitioners sent by regular U.S. mail to the Tax Court a notice of appeal in this case to the U.S. Court of Appeals for the Ninth Circuit; and (2) that notice of appeal (a) either may have been lost by the U.S. Postal Service, or (b) may have been lost after delivery to the Tax Court.  Attached to the Declaration of Sarah V. Waltner as Exhibit A, is a copy of Petitioners’ Notice of Appeal to the Court of Appeals for the Ninth Circuit.  Because this case is closed, petitioners’ Statement Letter to the Clerk of the U.S. Tax Court (With Ex.) may not be filed.

On August 15, 2016, the Waltners then admittedly filed a proper notice of appeal with the Tax Court.   But, the Ninth Circuit questioned whether the appeal was timely and sought briefing on this issue.  The DOJ argued that the appellate court lacked jurisdiction because the notice of appeal was untimely.

DOJ Argument

 Here are the links to the Baldwin Ninth Circuit appellant’s brief, appellees’ brief, and the reply brief.  Also, here are the links to the Waltner Ninth Circuit appellants’ brief, appellee’s brief, and the reply brief in the Ninth Circuit.  Although the two cases are not consolidated with each other, they have been scheduled to be argued one after the other before the Ninth Circuit in Pasadena on August 31, 2018.  And the DOJ briefs are clearly coordinated in their argument.

The DOJ arguments are predicated on the Treasury’s section 7502 regulation, Chevron, and Nat’l Cable & Telecomms. Ass’n v. Brand X Internet Servs., 545 U.S. 967 (2005).

As amended by 76 Fed. Reg. 52561-01 (Aug. 23, 2011), Reg. § 301.7502-1(e)(2)(i)provides, in relevant part:

Other than direct proof of actual delivery, proof of proper use of registered or certified mail, and proof of proper use of a duly designated [private delivery service] . . . are the exclusive means to establish prima facie evidence of delivery of a document to the agency, officer, or office with which the document is required to be filed.  No other evidence of a postmark or of mailing will be prima facie evidence of delivery or raise a presumption that the document was delivered.

The DOJ argues that section 7502, when enacted (and still today) is ambiguous as to whether it preempts the common law mailbox rule.  The DOJ contends that there is thus a gap to fill, which, under Chevron, can be filled by a reasonable regulation. The Circuit split over whether the mailbox rule has been preempted is evidence of two reasonable interpretations of section 7502.  The regulation is valid because it chooses one of those two reasonable interpretations.

In Brand X, the Supreme Court held that Chevron deference must even apply to a regulation that takes a position that has been rejected by a court, so long as the court opinion did not state that it found the statute unambiguous.  If the statute was unambiguous, then there can be no gap under ChevronStep One to fill.  PT readers may remember the extensive discussion of Brand X in the section 6501(e) Treasury Regulation case of United States v. Home Concrete & Supply, LLC, 566 U.S. 478 (2012).

The DOJ argues that Anderson did not describe its interpretation of section 7502 to still allow the mailbox rule as one required by an unambiguous statute.  Accordingly, under Brand X, the 2011 amendment to the section 7502 regulation is entitled to Chevron deference, in spite of Anderson.

We’ll see in Baldwin and Waltner if the government can effectively overrule Anderson by its regulation.

Observations

I will not needlessly extend this post by explaining my beef with the DOJ’s other arguments that compliance with the filing deadlines for refund claims under section 6511 and for notices of appeal under section 7483 are “jurisdictional” conditions of the courts.  I don’t think that either deadline is jurisdictional under current Supreme Court case law that makes filing deadlines now only rarely jurisdictional.  And, sadly, none of the taxpayers in these two cases made an argument that the filing deadlines are not jurisdictional – probably because it makes no difference in the outcome of their cases whether the filing deadlines are jurisdictional or not.  The taxpayers are not arguing for equitable tolling, just the mailbox rule (which is not an equitable doctrine that would be precluded by a jurisdictional deadline).  I only regret that I did not learn of either of these two cases earlier, when I could have filed amicus briefs raising the issue of whether the two filings deadlines are really jurisdictional.  At least the courts, then, might have noted that it is a debatable question whether these two filing deadlines are jurisdictional.

9th Circuit Opines on TEFRA Small Partnership Exception’s Application to Disregarded Entities and Punts on Issue of Deference Given to Revenue Rulings

Today Treasury re-released regulations under the new partnership audit regime, and that is a reminder that TEFRA is on its way out, putting pressure on me and my Saltzman/Book colleagues to finish our new chapter on partnership audits. Despite the new regime, courts, taxpayers and IRS still wrestle with TEFRA, which, given its complexity, will still produce developments for the blog and the treatise for the foreseeable future. Those developments include technical TEFRA issues, as here, but also broader issues of importance to tax procedure, including the degree of deference that courts should give to revenue rulings and when disregarded entities under the check the box regulations are not to be disregarded for all purposes.

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Last week the 9th Circuit in Seaview Trading v Commissioner considered one nook and cranny of TEFRA, the Section 6321 small partnership exception that applies when the partnership has “10 or fewer partners each of whom is an individual . . . , a C corporation, or an estate of a deceased partner.”

In Seaview, the father and son partners each held their interest in a partnership via single member LLCs that were organized under Delaware law. IRS audited the partnership and under TEFRA issued a final partnership administrative adjustment (FPAA) disallowing partnership losses relating to the 2001 year. The statute of limitations had long passed on the father and son’s individual 2001 tax returns if the TEFRA rules were not applicable. The son, on behalf of the partnership, filed a petition in Tax Court claiming that the FPAA was invalid because the partnership was exempt from TEFRA due to its qualifying for the small partnership exception. The Tax Court disagreed, and the Ninth Circuit, on appeal, affirmed the Tax Court. In so doing, it expounded on the relationship between State and Federal law and the deference given to revenue rulings.

In this brief post I will explain the issue and summarize the appellate court’s opinion.

As most readers know, the check the box regulations under Section 7701 disregard a solely owned LLC unless the owner elects otherwise. Regulations under Section 6321 provide that the small partnership TEFRA exception “does not apply to a partnership for a taxable year if any partner in the partnership during that taxable year is a pass-thru partner as defined in section 6231(a)(9).” TEFRA, at Section 6321(a)(9), defines a pass-thru partner as any “partnership, estate, trust, S corporation, nominee, or other similar person through whom other persons hold an interest in the partnership.” Section 6321(a)(9) predates the LLC and like entity explosion of the late 20th century, and there are no Treasury regulations that define LLCs and the like as a pass-thru partner.

The partnership in Seaview argued that under the check the box regulations, the LLCs that held the partnership were treated as sole proprietorships of their respective individual owners, and that consequently they could not constitute pass-thru partners within the meaning of the TEFRA regulations.

Despite the absence of regulations that address the issue of how interests held through single member LLCS are treated under the small partnership exception, the IRS, in Revenue Ruling 2004-88, specifically considered that issue. The revenue ruling held that a partnership whose interest is held through a disregarded entity ineligible for the small partnership exemption because a disregarded entity is a pass-thru entity.

In reaching its conclusion that the small partnership exception did not apply, the 9th Circuit addressed how much deference it should give to the IRS’s revenue ruling. The opinion notes that there is some uncertainty on the degree of deference to informal agency positions like revenue rulings. The court explained that in Omohundro v. United States the 9th circuit has generally given Skidmore deference to them. On the other hand, it noted that under the 2002 Schuetz v. Banc One Mortgage Corp., the 9th Circuit had given greater Chevron deference to an informal HUD agency position, and that there is some tension between the circuit’s approach in Schuetz and its approach in Omohundro.

It avoided having to resolve the tension between Omohundro and Schuetz by finding that the Service position in the revenue ruling was correct even when applying the less deferential Skidmore standard. The Skidmore test essentially means that courts defer to the position if it finds it persuasive. As the opinion describes, factors that courts have considered in analyzing whether a position is persuasive include the position’s thoroughness, agency consistency in analyzing an issue and the formality associated with the guidance.

The taxpayers in Seaview essentially hung their hat on the revenue ruling’s rather brief discussion of the sole member LLC issue, but the court nonetheless found the ruling persuasive and also consistent with other cases and less formal IRS counsel opinions that likewise considered the application of the small partnership exception to disregarded entities.

For those few readers with an appetite for TEFRA complexity, I recommend the opinion, but in a nutshell the court agreed with the Service approach that looked first to how the statute’s language did not reflect a Congressional directive to limit the exception to only listed entities. As the opinion discussed, Section 6321(a)(9) defines a pass thru partner as a “partnership[s], estate[s], trust[s], S corporation[s], nominee[s] or [an]other similar person through whom other persons hold an interest in the partnership.” Noting that the statute itself contemplates its application beyond the “specific enumerated forms” the question turns on “whether a single- member LLC constitutes a “similar person” in respect to the enumerated entities.”

The opinion states that “Ruling 2004-88 holds that the requisite similarity exists when ‘legal title to a partnership interest is held in the name of a person other than the ultimate owner.’ ” That line drawing, in the 9th Circuit view, was persuasive, and the revenue ruling had in coming up with the approach cited to and briefly discussed cases that supported the IRS position, including one case where a custodian for minor children was not a pass thru partner because he did not have legal title and another case where a grantor trust was a pass thru partner because it did hold legal title.

One other point, the relationship between state and federal law, is worth highlighting. The taxpayers gamely argued that the IRS view impermissibly elevated state law considerations to determine a federal tax outcome. The court disagreed:

But the issue here is not whether the IRS may use state-law entity classifications to determine federal taxes. Rather, the question is whether an LLC’s federal classification for federal tax purposes negates the factual circumstance in which the owner of a partnership holds title through a separate entity. In other words, state law is relevant to Ruling 2004-88’s analysis only insofar as state law determines whether an entity bears the requisite similarity to the entities expressly enumerated in § 6231(a)(9)—that is, whether an entity holds legal title to a partnership interest such that title is not held by the interest’s owner.

Conclusion

The Bipartisan Budget Act (BBA) new rules for partnership audits begin for returns filed for partnership tax years beginning in 2018. As partners and advisors navigate the uncertain waters of a new BBA partnership audit regime, TEFRA and its complexity will be with us for some time.

The BBA regime has opt out procedures for partnerships that have 100 or fewer qualifying partners. Essentially the statute states that all partners must be individuals,  C corporations, or any foreign entity that would be treated as a C corporation were it domestic, an S corporation, or an estate of a deceased partner. While silent on the treatment of disregarded entities, the BBA statute also states that Treasury and IRS by “regulation or other guidance” can prescribe rules similar to the rules that define the category of qualifying partners. 

Proposed Treasury regulations under the BBA were in limbo but earlier today Treasury re-released regulations that provide guidance for the new regime. The proposed BBA regulations specifically address disregarded entities. Despite comments in response to an earlier notice asking Treasury to allow disregarded entities to be treated as qualifying partners, the proposed regulations do not include disregarded entities as qualifying partners and the preamble specifically states that Treasury declined to do so because “the IRS will face additional administrative burden in examining those structures and partners under the deficiency rules.”

The upshot is that for under both TEFRA and likely BBA disregarded entities holding interests in a partnership mean that the general partnership audit rules will apply.

 

 

 

 

Good Fortune (for the IRS)

This week the Tax Court in Good Fortune Shipping v Commissioner,148 TC No. 10 upheld regulations relating to the exemption of income from the international operation of ships. Taxpayers are frequently teeing up issues relating to the validity of regulations, and this opinion is an important victory for the government. I will briefly describe the case and the way the Tax Court resolved the dispute.

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The statutory scheme under Section 883 (wildly simplified) is that gross income attributable to international shipping activities is exempt from US tax if the foreign country in which the corporation is organized grants an equivalent exemption to corporations organized in the United States. In Good Fortune the owners of the shipping company were in fact residents of a country that did grant a similar exemption, but the shareholders held the stock in bearer form rather than in registered form. The statutory scheme tied the exemption to shares “owned by individuals” of a reciprocating foreign country; the regulations additionally restricted the benefit to shares that were owned in a certain way, and in particular excluded from the possible statutory exclusion scheme shares that were owned in bearer rather than registered form.

Bearer ownership and transferability is generally evidenced by physical delivery; registered form ownership ties ownership to a name that is registered with the corporation or its agent. US tax law has generally frowned on conveying benefits that are dependent on residence of ownership when shares or securities are held in bearer form for the obvious reason that it is easy to circumvent rules that are meant to tie exclusions or reduced withholdings on beneficial ownership in a particular jurisdiction when ownership can be conveyed just by possessing the security. Bearer form ownership promotes privacy, which is a value that tax agencies weigh quite differently than taxpayers.

In Good Fortune, in upholding regulations that essentially stated that bearer shares of a foreign corporation may not be taken into account in establishing the ownership of the stock of the foreign corporation, the Tax Court, applying the two-step Chevron analysis, leaned heavily on Mayo in finding that Congress had not spoken directly on the issue (step 1) and ultimately concluded that the regulations in place for the year in question were a permissible construction of the statute (step 2).

In finding that the precision needed was lacking in Step 1 the opinion emphasized that there was a legislative gap in how to prove ownership:

The words “owned by individuals” in section 883(c)(1) do not, as petitioner appears to acknowledge, explain or otherwise address how to establish ownership by individuals for purposes of section 883(c)(1), let alone how to establish ownership where the shares of the foreign corporation are owned in bearer form. The dictionary definitions of the word “own” on which petitioner relies which petitioner claims are unambiguous definitions, do not address the problem under section 883(c) of determining how to establish ownership by individuals for purposes of section 883(c)(1) that the Internal Revenue Service (IRS) confronts when it examines a return of a foreign corporation seeking the benefits of section 883(a)(1) for a prior taxable year

Upon reaching Step 2, the opinion looked to legislative history to 1986 statutory changes that tied the reciprocal exemption to corporate ownership rather than just the location of where the ship was registered:

A foreign corporation’s entitlement under section 883(a)(1) to exclude certain income from gross income and exempt that income from U.S. tax no longer was based solely upon the country in which the foreign corporation’s vessel was registered or documented. Instead, Congress added in its amendment of section 883 in the 1986 Act a second hurdle to that favorable treatment by enacting section 883(c) in order to curb abuse by residents of certain foreign countries who owned stock in a foreign corporation that was seeking the benefits of section 883(a)(1) where those foreign countries did not provide an equivalent exemption to U.S. corporations.

With that context the opinion discussed how bearer shares, which tie ownership to physical delivery, “make it virtually impossible to know who the actual shareholders or owners of a corporation are because the only proof of ownership is physical possession at a particular point in time of the paper bearer share certificate.” The absence of a registry contributes to ownership anonymity. As such, it was a short step for the court to conclude that the regs passed muster under Step 2:

We conclude that the bearer share regulations do not contravene section 883(c)(1) but are a reasonable construction of that section which provides the IRS with the appropriate tools needed to enforce section 883. The bearer share regulations provide certainty and resolve the difficult problems of proof associated with establishing ownership of bearer shares, especially for prior taxable years. In not allowing bearer shares to be taken into account in establishing the ownership of the stock of a foreign corporation for purposes of determining whether the foreign corporation is described in section 883(c)(1) and thus whether it is entitled to the benefits of section 883(a)(1), the bearer share regulations set forth a sensible approach to effecting the intent of Congress in enacting section 883(c)(1) to ensure that abuse will not occur which will result in certain types of shipping transportation income described in section 883(a)(1) not being taxed.

Good Fortune shows how in the absence of statutory detail on implementation, agencies have considerable discretion in promulgating rules, especially true when the rules relate to exemptions, which as the Tax Court noted here, are to be interpreted narrowly.